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FINANCIAL LAW INSIGHT - IT'S COFI TIME!
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On 25 September 2019 the Government announced the proposed introduction of a new regulatory regime to govern conduct in the financial sector. This represents the next stage in the Conduct of Financial Institutions (‘CoFI’) review, with legislation to implement the new regime scheduled to be introduced to Parliament before 2020. In this Financial Law Insight we unpack the headline decisions that have been made, and consider the implications of the new regime.

The Government announcement comes as no surprise. In 2018 the FMA and the RBNZ commenced joint reviews into the conduct and culture of banks and life insurers in New Zealand. Their findings in relation to banks were published in last November, and in relation to life insurers in late January. Those reviews identified a number of issues with bank and life insurer conduct.

Setting the scene for the latest announcements, the reviews also identified a gaping hole in the framework for regulating bank and insurer conduct.

Following on from the joint reports of the FMA and RBNZ and the findings of the Australian Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry, in the 2nd quarter this year MBIE consulted on potential options to improve the conduct of financial institutions through the release of an options paper (‘Options Paper’). 

Kensington Swan provided one of the 85 submissions which were made in response to the Options Paper. We were generally supportive of the concept of an overarching set of conduct duties applying to entities licensed to provide financial services. We also raised a number of concerns as to the extent of the additional regulatory burden that some of the proposed options would place upon a sector already straining under the load of multiple regulatory reforms, reviews, and investigations, with the prospect of unintended negative consequences.

MBIE’s high-level objective in reviewing the options for regulating the conduct of financial institutions is to ensure that conduct and culture in the financial sector is delivering good outcomes for customers. The proposed new regime announced in June clearly has that outcome as its objective - but at what cost for the market participants charged with delivering those good outcomes?

The new regime in a nutshell

The minutes of the Cabinet decision to approve the new regime record the following key decisions:

  • a new conduct licensing regime will be created for banks, insurers and non-bank deposit takers (‘NBDTs’), with licensing administered by the FMA
  • licensed entities will be required to meet a ‘fair treatment’ standard, with effective policies, processes, systems and controls needing to be put in place to meet that standard
  • the scope of financial products and services to be covered by the regime will be determined by regulation, with regulations and licence conditions also able to specify the details of the requirements for the requisite policies, processes, systems and controls
  • FMA will have the ability to review licensed entities’ policies, processes, systems and controls at any point, and require amendments
  • banks, insurers, and NBDTs will be accountable for the conduct of any intermediaries that distribute their products that are not financial advice providers under the Financial Services Legislation Amendment Act 2019 (‘FSLAA’) reforms
  • regulations or licence conditions may be imposed to create oversight and responsibility arrangements in relation to financial advice providers
  • banks, insurers, and NBDTs will be subject to obligations regarding how they design their remuneration and sales incentives and how they manage the risks those incentives create, with a prohibition on sales incentives based on volume or value targets at the core of those new obligations. The intermediaries used by banks, insurers and NBDTs will also be subject to those same prohibitions.

What hasn’t been included?

A number of options that were canvassed in the Options Paper are not being progressed at this time, as they were considered not critical to achieving a core regime for regulating the conduct of financial institutions. This includes options for product intervention powers and product design and distribution obligations. However, it seems clear that it is just a matter of time before those options find their way into the new regulatory regime in some shape or form.

One key option not included in the September Cabinet decisions is increased accountability for financial institution senior executives (e.g. managers and directors) for the conduct of the institution. Instead, that option has been ear-marked for progression in the short term. We strongly opposed this proposal in our submission on the Options Paper, given the chilling effect it is likely to have on innovative practices and those involved. We are pleased that this particular option did not find its way into the initial Cabinet decisions, but remain concerned that proposals for increased executive accountability are progressing.

We believe the current regulatory mechanisms for executive accountability strike an appropriate balance and are fit for purpose. This option is unlikely to best serve the long-term interests of consumers. In our view, the cons of adding an additional layer of executive accountability significantly outweigh the perceived benefits.

Unfortunate timing

It is curious that the brave new world for licensing financial advice providers and regulating their activities through a new set of conduct duties and a code of conduct is just months away from being implemented, yet Cabinet has now seen fit to recommend a separate layer of conduct obligations that will impact on financial advice providers.

The financial sector has been investing significant resources in coming to grips with the regulatory burden and complexity that is being generated through the FSLAA reforms. That regime has been in development since 2016, with multiple exposure drafts and consultations to ensure the new regime has most of its kinks ironed out before implementation.

With the draft CoFI legislation due to be introduced to Parliament in less than three months’ time, the same measured approach to legislative development will not be possible. Some of the rushed decisions made look set to cut across – or at least complicate – plans financial institutions have been developing for managing intermediary conduct risk. This is unhelpful at this late stage.

You also have to question the prioritisation of MBIE's resources towards this latest reform. FSLAA received the Royal Assent in April. Since that time, financial advice providers have been crying out for draft disclosure regulations, so they can put some meat on the bones of their preparation for a new financial advice regime that is now less than nine months away. The delay in getting those regulations progressed is starting to create significant challenges for the development of innovative tech-based solutions to support the new regime.

In the political rush to be seen to have ‘done something’ about the identified regulatory gap, eyes seem to have been taken off the current regulatory reform ball in play. This observation is not a criticism of the MBIE team charged with making the regulation happen. The amount of work that team has been managing in recent times is nothing short of remarkable. Rather, with limited resources at his disposal, there is a cost to the Minister appearing to have diverted some of that resource to the development of new reforms, when an existing reform is in its final critical stages of development before going live.

Impact on intermediaries

Putting aside the potential curve ball that the CoFI review has thrown at the FSLAA reform process, the headline decisions announced by Cabinet last month are going to have some significant implications for those involved in the distribution of banking and insurance products.

The pending prohibition on sales incentives based on volume or value targets has been well signalled. Most providers have already abandoned overt soft commissions such as overseas trips, and many are well down the track in revising remuneration structures to remove bonuses for achieving financial products sales targets.

Prohibiting performance management based on the volume of sales, at least for organisations dependent on the sale of products for financial survival, might be a harder one to put in place – but imposing such a prohibition comes as no surprise. What was less predictable is that prohibitions put forward as part of the regulation of conduct of banks, insurers and NBDTs will also apply to their intermediaries. These are the individuals and entities who will come under the FSLAA licensing regime. Why, then, were these prohibitions not considered necessary as part of the FSLAA reforms? The old saying ‘second bite of the cherry’ springs to mind…

The obligations that will be imposed on financial institutions in relation to remuneration and other sales incentives, and how they must manage the risks those incentives create, will be interesting to see in detail. Once again, the obligations will only apply to banks, insurers, and NBDTs (initially at least). The objective is to address the risk of sales incentive structures leading to sales being prioritised over good customer outcomes.

Minister Faafoi stresses a couple of times in the Cabinet paper that the intention of the obligations being imposed is not to ban commissions, but to minimise the risks of harm to customers that arise from particular remuneration and incentive structures. Easy to say, harder to translate into practical regulation that effectively manages the distinction.

Of the various mechanisms to address the conduct of intermediaries, the one that may well have the biggest impact on business practices is the decision to render licensed entities accountable for sales made by intermediaries who are not subject to the new FSLAA regime. In essence, where a bank, insurer, or NBDT is distributing product through an intermediary that is not a licensed financial advice provider, the bank/insurer/NBDT in question will need to take responsibility for the outcomes for their end customers, and will need to manage this responsibility through their distribution agreements.

In contrast, licensed entities will not be directly accountable for any advice provided by or on behalf of licensed financial advice providers. Having said that, the Cabinet paper does go on to note that banks, insurers, and NBDTs will still be expected to take action to ensure the objectives and needs of their customers are met, through initiatives such as training, setting conduct expectations, provision of information, and taking action where they become aware of issues. That expectation applies irrespective of the distribution channel.

What the above distinction is likely to reinforce is a business practice that is already starting to play out, with a number of banks and insurers making the business call to say they will only deal with licensed financial advice providers once the new FSLAA regime comes into effect. This will not be a practice that is feasible for all, but it will challenge the viability of some business models, especially those involving non-adviser intermediaries where finance and insurance is sold as an incidental part of the main business activity.

What it all means is that banks, insurers, and NBDTs may no longer view information-only distribution channels as safe harbours, relatively free from regulatory risk. If nothing else, this renders the licensed financial advice provider model more attractive as an intermediary proposition than was previously the case.

Scope and implementation

Despite the insurance side of last year’s FMA/RBNZ reviews of conduct and culture being limited to life insurers, the new CoFI regime looks set to apply to all insurers – life, general and health alike. The expectation is that the flexibility provided by regulation and licence conditions will result in a risk-based approach. That may result in the new regime imposing less of a regulatory burden on insurers who are not involved in life insurance. That remains to be seen. The decision for now is that all will be brought within the conduct licensee net.

Excluded from the new regime, for the time being at least, will be fund managers, and KiwiSaver scheme and DIMS providers. At one level, these entities are already part of the licensed community under the Financial Markets Conduct Act 2013 (‘FMC Act’) so are already answerable to the FMA for their conduct. At another level, however, there appears to be a titling of the playing field, with fund managers who are part of a banking or insurance group potentially subject to an additional set of conduct obligations when compared with their competitors.

Implementation

How is this all going to be brought into effect? By adding yet another leg to the FMC Act, of course!

There is a lot of sense in leveraging off the existing licensing mechanics of the FMC Act to include the new CoFI licensing regime, as opposed to enacting an entirely separate licensing regime, or expanding RBNZ’s role to pick up a conduct licensing remit. Where we see inefficiencies arising is in the number of FMC Act licences that will need to be maintained by banks and insurers once the new regime comes into effect. The alternative (and one we had proposed in our submission on the Options Paper) is to simply incorporate conduct obligations into the obligations imposed on licensed entities, thus avoiding the need to apply for and maintain a separate conduct licence.

The outcome of the path taken with the CoFI reforms is that a piece of legislation that is already one of the most complex in the New Zealand legislative framework is set to become even more complicated and lengthy. As if FSLAA’s inclusion within the FMC Act of financial advice and client money and property handling wasn’t enough!

What next?

While all this is bubbling along, we still have the outcome of the review of insurance contract law to look forward to. Somehow, we don’t think this particular set of reforms will find its way into the FMC Act, but given the enthusiasm shown for growing that legislation to date, we wouldn’t bet against it.

At the time of writing, we are still awaiting the release of the draft FSLAA disclosure regulations. We are also expecting a raft of implementation and exception regulations to bring the FSLAA reforms into effect, and the FMA is consulting on possible exemptions from the FSLAA regime.

Reforms to the responsible lending regime under the Credit Contracts and Consumer Finance Act 2003 are also still in train. These are currently scheduled to come into effect in March 2020.

The CoFI review and new conduct licensing regime is going to influence all of the above – if not directly, then behind the scenes in the form of the systems and processes that market participants will need to put in place to ensure they are operating in accordance with regulatory expectations.

Draft legislation to implement the outcome of the CoFI review is expected by December 2019. The clear message for all market participants (and not just banks, insurers, and NBDTs) is to not sit back and wait for the detail of the legislative reforms before acting. Most market participants will already be well advanced with their conduct and culture review action plans (by whatever name they might be called). Last month’s Cabinet paper provides some further content to feed into those plans, and into the systems and processes being developed for FSLAA.

These are interesting times.

Start a conversation

If you would like a specific briefing on the CoFI Review, what it may mean for your business and your arrangements with other market participants, or would like assistance with reviewing your business practices to better position yourself for the future regulatory landscape, please contact Catriona Grover on +64 4 498 0816, David Ireland on +64 4 498 0840, Pauline Ho on +64 9 909 6345,  Megan Mcluskie on +64 4 498 0876 or Nick Beresford on +64 9 375 1150, or email the team at bankingandfinancialmarkets@kensingtonswan.com.

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